Houston attorney Tom Kirkendall, author of the website Houston’s Clear Thinkers, provides a copy of Charles Markopolos’s 2005 notice to the SEC concerning likely fraud at Madoff Securities. Markopolos gives two scenarios, the first concerns front running, which he calls unlikely, and the second (likely) scenario charges Madoff Securities with running the world’s largest Ponzi Scheme.

Markopolos did not sign or put his name to the report, and asked the SEC to keep his identity secret from everyone but the Branch Chief and Team Leader in the SEC New York Region assigned to the case. He explicitly stated that he feared for his and his family’s safety. I don’t know if Markopolos was being unnecessarily paranoid, or if Madoff went beyond mere fraud to serious gangsterism. The failure of the SEC to investigate, and the protracted nature of this gigantic fraud suggests something is pretty rotten in Denmark. [LA replies: But Kirkendall, in his blog entry that links the Markopoulous memo, takes the opposite view. See my comment below.] The SEC once had a teenager arrested in New Jersey, charging him with “pump and dump” because he extolled the virtues of a stock on a Yahoo discussion group. How can the SEC miss a whale while catching the minnow?

Markopolos presents a series of red flags that mostly deal with the technical aspects of option trading, and how Madoff could not have been using a split-strike conversion strategy to achieve his reliably positive returns. However, Markopolos was informed that Madoff was trading OTC (over the counter) options through UBS and Merrill Lynch and strongly suggested that SEC visit them to verify that the OTC trades had taken place, and if they can’t show the offsetting hedge positions then UBS and ML are assisting Madoff in the fraud. Thus we should see more arrests in the near future. If we don’t then Madoff is falling on his sword to protect more than just his sons. How could a single person maintain a $50 billion fraud?

Markopolos’ Red Flag Number 11 shows that at least two articles questioning Madoff appeared in the financial press, one in Barrons on May 7, 2001 and one by Michael Ocrant who visited the Madoff offices and wrote a very negative article about the sources of Madoff’s returns. Ocrant observed suspicious behavior which provides further evidence of other conspirators. Why was there no follow up on these articles either by the SEC or other enforcement agencies? How is that Madoff could continue operating when enough red flags appeared in enough places that clearly established prima facie evidence of a Ponzi Scheme? The Madoff case could be only the start of a massive unraveling a corruption monster at the heart of America’s largest industry.

LA replies:

Mr. Zarkov wrote: “The failure of the SEC to investigate, and the protracted nature of this gigantic fraud suggests something is pretty rotten in Denmark.” But Kirkendall takes the opposite view. He says that it’s foolish to blame the SEC and seek to re-arrange the deck chairs of the regulatory agencies. He writes:

The primary justification for this regulatory retrofitting is the plight of the innocent investors (and it sure is an interesting bunch) who lost millions when Madoff’s company went bust. Although nothing is wrong with compassion for folks who lose money in an investment fraud, it’s important to remember that those investors who lost their nest egg in the Madoff implosion were imprudent in their investment strategy. They should have diversified their Madoff holdings or done some real due diligence into his operation if they were going to bet the farm on it. Even though every one of Madoff investors carry insurance on their homes and cars, one can only speculate why they didn’t attempt to understand the risk of their investment in Madoff’s company better than most did. Most likely, many of the investors simply did not care to truly understand how Madoff claimed to create wealth for them in the first place.

Thus, as Larry Ribstein has been advocating for years, no amount of increased regulation is likely ever to do a better job than the market in mitigating fraud loss. It’s easy to throw Madoff in prison for the rest of his life, simply attribute the investment loss to him and pledge to do a better job of policing the crooks next time. It’s a lot harder to understand how Madoff’s investors could have hedged their risk of Madoff’s fraud. As this WSJ editorial concludes, “expecting the SEC to prevent a determined and crafty con man from separating investors from their money is no more sensible than putting your life savings with a Bernard Madoff.”